Trump promises new regulatory overhaul
Just when it looked as if the direction of travel on banking regulation was set along comes an event – in this case Donald Trump’s US election victory – that seriously undermines that assumption. By Justin Pugsley
The feeling that has emerged since then can be summed up by the title of a new film: Rules Don’t Apply. Ironically, one of its producers, ex-Goldman Sachs banker Steven Mnuchin, has been nominated by Donald Trump as US Treasury secretary.
The incoming Trump administration, which kicks off on January 20, 2017, promises a clean sweep of the US regulatory system with possible consequences for global accords such as Basel III/IV.
Also, the Republican president-elect looks set to be disruptive, espousing a radically different style to his predecessors. Policy announcements are often made over Twitter, and Trump’s aims for his first 100 days were broadcast via YouTube.
Mr Trump embodies unpredictability, meaning that at this stage not much can be taken for granted. “Anything could happen. This is going to be a very unpredictable time,” says Gary DeWaal, special counsel with law firm Katten Muchin Rosenman.
Fran Reed, a regulatory strategist at data and software firm FactSet, warns that if Mr Trump is too disruptive, however, confidence could be dented. “If he is tempered by his team then that should shore up confidence from a business point of view,” he adds.
During the election campaign, Mr Trump declared that over-regulation costs the US economy $2000bn a year. In the financial sector, the focus of that ire is the Dodd-Frank Act, drafted under the current Democratic administration. It is a 2,300-page tome encompaasing 400 new rules and mandates generating another 22,000 pages of material, designed to make the US financial system safe.
And there are a number of people salivating at the prospect of slaying Dodd-Frank. The American Action Forum (AAF), which promotes centre-right ideas, blames the act for creating $30bn in regulatory costs. About two thirds of the rules have been implemented at great cost to banks.
Many of the larger banks do not relish the idea of starting on a new framework, however. At least Dodd-Frank compliance enables them to claim that too-big-to-fail has been addressed.
The death of Dodd-Frank?
But Mr Trump wants to bin Dodd-Frank, blaming it for stifling credit to the economy. That is debatable, however.
Data from the Federal Reserve shows that total credit advanced by commercial banks has risen at a steady clip since 2011 to stand at a record $12,400bn on November 9, 2016, compared with $9,500bn in October 2008, the previous peak.
However, growth is uneven. It has been skewed towards big corporates while certain areas of consumer finance and small business lending have lagged behind. This is partly due to tougher rules aimed at preventing a repeat of the sub-prime crisis.
But can Dodd-Frank be repealed? What would replace it? Or how might it be amended? And how would that affect global accords such as Basel?
“Mr Trump was clear about what he views as excessive financial regulation and his intent to seek repeal of Dodd-Frank,” says Dan Hawke, a partner with law firm Arnold & Porter. “Congressional Republicans who are opposed to Dodd-Frank will likely see this as their best chance to eliminate or significantly modify it."
He adds that this is consistent with the positions Mr Trump took during the campaign and it is likely that senior positions in federal financial agencies will be filled by those known to favour a lighter regulatory touch.
“As the president-elect assembles his team there will continue to be stories about what is and isn’t in play, some trial balloons, some speculation, but probably not a lot of actual fact," says David Weinfurter, global head of financial institutions at Fitch Ratings.
Given the anti-Wall Street rhetoric abroad in the US, he believes that the new administration will be cautious in its reforms, not wanting to be seen to be making “gifts” to the big banks.
“I don’t expect lighter regulation. I think there might be a move to refresh regulation to make sure that it is as effective and efficient as possible,” says Mike Roemer, group head of compliance at Barclays Bank.
Right now, few expect Dodd-Frank to be scrapped. Doing so would be enormously costly and time-consuming. Besides, Mr Trump has an ambitious agenda including tax cuts, infrastructure spending and vast trade and regulatory reforms.
“I think rather than repeal Dodd-Frank, they’re going to fine-tune it and cherry-pick the bits they like,” says Colin Lawrence, head of strategy and research at consultancy Parker Fitzgerald. “Financial reform is not their highest priority, so I think it’s going to be a slow-burn process. They’ll change things like governance of the regulatory agencies, for example.”
Industry sources believe that Mr Trump can probably achieve most of his objectives via amendments to Dodd-Frank, which would be more efficient than starting again. However, some think his combative leadership style could result in high turnover of key staff, which could slow his reform programme.
The choice act
A possible blueprint for those reforms is the Financial Choice Act drafted by Jeb Hensarling, the Texas Republican congressman who chairs the House Financial Services Committee. It would not repeal Dodd-Frank, but would change it significantly. It advocates replacing the Orderly Liquidation Authority (OLA) with an amended bankruptcy code.
It proposes managing financial risk more through market discipline and focusing on simplicity, and enhancing accountability.
However, rules governing over-the-counter derivatives, for example, would be left largely intact, and there’s no mention of the Glass-Steagall Act, repealed in 1999, but mentioned for reintroduction by Mr Trump during the campaign. Glass-Steagall separates riskier investment banking activities from retail operations.
Among the Financial Choice Act’s many proposals is the chance for some banks to opt out of much of Dodd-Frank provided they have a leverage ratio of 10%. This would mean exemption from capital and liquidity requirements including those stipulated by the Basel Committee on Banking Supervision (BCBS).
They would also need to score one or two on the CAMELS rating, which is a supervisory rating system covering capital adequacy, asset quality, management capability, earnings, liquidity and market risk-sensitivity.
Other measures include closing the Office of Financial Research, downgrading the Financial Stability Oversight Council (FSOC) so it is no longer able to designate non-bank financial firms as systemically significant. The act would retain the Consumer Finance Protection Bureau (CFPB), but in a diminished form.
It would also limit the Federal Reserve’s and the Treasury’s lending authority under the exchange stabilisation fund, significantly reduce the Securities and Exchange Commission’s (SEC) powers, and repeal the Federal Deposit Insurance Corp’s (FDIC) systemic risk powers and its ability to manage temporary liquidity guarantee programmes.
It would also remove the Volcker rule, which bans banks from proprietary trading.
In a client memorandum, law firm Davis Polk & Wardwell describes the Financial Choice Act as “a starting point that signals a potential general direction of travel for financial reform … A Republican congress and administration will have more ambitious plans for a significant reorientation of the regulatory framework”.
The act envisages greater accountability for the regulatory agencies. For participation in international bodies such as the Basel Committee and the Financial Stability Board (FSB), there would be a requirement for public notices and comments. Also, any major new rules would need Congressional approval and a cost-benefit analysis.
Mr Hensarling has said he is to start work on a Financial Choice Act 2.0.
Among the easier wins for Mr Trump, as there is cross-party support, is to help community banks. Dodd-Frank has been hard on them, leading many to close. They can be helped by raising the thresholds at which various rules kick in. For example, revising the qualified mortgage rule and simplifying anti-money laundering guidelines would support their viability.
“At $10bn, stress testing kicks in for smaller banks and at $15bn you lose some of the capital benefits from hybrid securities and this disproportionately affects the smaller banks,” says Joo-Yung Lee, North American head of financial institutions at Fitch Ratings.
She adds that there has already been some tiering of regulatory requirements for the larger banks greater than $50bn, and that the latest comprehensive capital analysis and review (CCAR) proposal and new proposals look to roll back some of the requirements for banks with less than $50bn in assets.
Delivering on some of the other measures on the Republicans’ wish list will be more challenging.
The Consumer Financial Protection Bureau (CFPB), a Dodd-Frank creation, is a case in point. Shutting it down, as demanded by some Republicans, might be a step too far, say industry sources. It was established to protect consumers, and getting rid of it would not chime with Mr Trump’s populist agenda of defending Main Street from Wall Street.
The recent Wells Fargo scandal, in which employees illegally opened unauthorised accounts for customers, may strengthen the case for keeping the CFPB. However, its powers are likely to be curtailed. Currently, it is very independent, despite a federal appeals court ruling that limiting the US president from being able to remove the CFPB director was unconstitutional.
When the CFPB began life in 2011, it was given extensive independence to make it immune to political interference. However, director Richard Cordray has been controversial, earning many enemies in the Republican party, and is likely to be replaced.
In future, the agency will probably answer to Congress, which may also assume more control over its funding and amend its governance structure so that there would be commissioners on its board.
US stress tests under CCAR are generally well regarded for being tough and for driving better prudential standards within the banking industry.
CCAR is not expected to be ditched, but there is talk of making the process more transparent and accountable. For example, the models used by the Federal Reserve are not revealed and many of its findings are also not publicly aired. The former irritates the industry and the latter politicians.
Many of those views were given credence by a report from the Government Accountability Office, which criticised the Fed for incomplete disclosure of its bank capital adequacy assessments.
It said its opaqueness hinders public and market confidence. It also felt that the Fed should give more regular guidance to banks about its expectations and peer practices as part of its qualitative assessments.
Hensarling who ordered the report reiterated the lack of transparency and the often duplicative and unnecessary costs heaped on banks that get passed to consumers.
There is therefore some political momentum to review CCAR.
However, there are concerns that if some of the processes become more transparent then it could damage CCAR’s credibility. For example, knowing what models the Fed is using and removing some of the ambiguities in the regime could see the industry gaming the system, according to some industry sources.
Another body in the Republican’s cross-hairs is FSOC. Some industry sources believe it will be scrapped, others think it will be cut down to size.
Like FSOC, the Volcker rule has been nominated for termination by the financial choice act. One of Trump’s closest advisors, Paul Atkins who was an SEC commissioner certainly wants it dead.
However, doing so could be controversial as it would play against Trump’s populist mantra and could be interpreted as giving the big banks a free hand to make vast profits at the expense of financial stability.
However, it’s far from clear whether banks would rush back into proprietary trading in the US if given the chance.
“If the Volcker rule was removed or changed, I don’t necessarily see banks once again increasing their proprietary trading,” says Vuk Magdelinic, CEO of fixed income platform, Overbond. “The market has changed with new players, such as hedge funds moving in and the banks aren’t positioned to just re-start proprietary trading.”
There is also some doubt hanging over the future of the OLA, part of the Federal Deposit Insurance Corp (FDIC). The Authority was set up under Dodd-Frank to handle the wind-down of large systemically important financial institutions should they become insolvent.
It’s a special purpose bankruptcy regime for large financial institutions and was born out of the Lehman Brothers collapse, which nearly destroyed the financial system. OLA was designed to contain the systemic risks as the normal bankruptcy regime does not account for financial stability.
However, for many Republicans it implies back-door bail-outs and an inducement to moral hazard. It could therefore be substantially revised according to industry sources.
Derivatives & clearing
At this stage, there aren’t any expectations for fundamental reforms for derivatives – though there could be some changes.
J Christopher Giancarlo, a Republican commissioner on the US Commodity Futures Trading Commission (CFTC) has routinely condemned the regulatory authority’s swaps trading reforms, which he blames for fragmenting and draining liquidity from those markets.
He believes the CFTC’s approach is over-engineered, modelled too much on the US futures market and discriminates against human discretion and technological innovation. Some of the contents of his white paper: ‘Pro-Reform Reconsideration of the CFTC Swaps Trading Rules: Return to Dodd-Frank’ could work their way into the new administration’s regulatory agenda.
It’s been suggested that whereas the Financial Choice Act is a high-level wish list, white papers such as Giancarlo’s offer the finer details on implementation.
Swap Execution Facilities, for instance, could be subject to less rules as Giancarlo feels they exceed Dodd-Frank’s mandate. Given that not all the derivatives rules are fully implemented there might be scope for the new administration to make changes relatively easily.
In terms of clearing, particularly for OTC derivatives, there seems to be little appetite to make significant changes, despite industry complaints over compliance costs.
“Even though some of the regulations around clearing have been painful for users, they have now adapted to them,” explains a derivatives specialist with a continental European bank. “They see them as reducing risk so even if those rules were abolished or significantly amended, I think many users would want to keep clearing.”
He added that the trend is for users to diversify their counterparty risk exposures as much as possible and clearing plays to that theme.
Watch the appointments
However, the evolution of US regulation will not be dictated just by Trump or the various documents that have been published by Hanserling, Giancarlo and others.
“In terms of policy making much depends on who is selected to do the job. To some degree who is sitting in the chair is probably as important as the overall party platform because it is relatively under-specified,” says Nathaniel Lalone, partner with law firm, Katten Muchin Rosenman.
A potentially big influence in the new administration is Paul Atkins who is on Trump’s transition team. His influence is likely to be strongly felt on the SEC, where he was a former commissioner. Not only could he have a sway on who runs the regulatory agencies generally, but may end up chairing the SEC, though he does still head up the regulatory consulting firm he founded, Patomak Global Partners.
Atkins has been critical of SEC rules covering best price execution and the Regulation National Market System saying they fragment markets and harm price discovery. He’s criticized the Public Company Accounting Oversight Board, which writes rules for corporate auditors, for being too prescriptive and constraining on auditors. He also has strong views on market conduct.
This could lead to SEC reforms and some worry it could undermine the agency’s effectiveness.
Basel demands for high capital and liquidity requirements seem to collide with Trump’s deregulation pledge, particularly if he believes they stifle lending.
It is notable that the drive for tougher banking rules is from the US. Daniel Tarullo, who is on the Fed’s board of governors has been one of the prime movers behind tough rules, much to the consternation of European banks leading to John Cryan CEO of Deutsche Bank to label Basel as only benefiting US banks.
There has been talk that the new administration may try and side-line Tarullo from regulatory matters and eventually remove him from the Fed. For instance, the new administration may want to dilute capital requirements to spur more lending into infrastructure renewal, though much of that funding will probably come from the capital markets.
But industry sources say there are limits over what can be done. “It’s going to be difficult to roll back a lot of the rules that have been made and structurally implemented and are in full practice in US,” says Factset’s Mr Reed.
But with some Europeans threatening to walk away from the Basel accords over proposals to limit the use of internal models and with the US potentially diverging even further, there’s a real risk that Basel III/IV could end up being largely symbolic.
In its client memorandum, Davis Polk & Wardwell wrote that the choice act and EU policymakers rejecting certain Basel capital standards is a source of concern for the setting of international standards. “The new Administration may decide to participate more lightly in international processes as a policy matter,” the firm wrote.
Implementation of Basel rules has anyway seen considerable variation across jurisdictions. A big US emphasis is CCAR. One former regulator said the Europeans worry that the US pays too little attention to parts of the Basel framework, such as Pillar 2 requirements dealing with the supervisory review process. Also, some US supervisors apparently see sections of Basel as unnecessarily complex.
“Ultimately, I don’t think the US will walk away from Basel or the FSB. It would be too disruptive and undermine confidence in international markets,” says Mr Lawrence.
In March, the European Central Bank found that the capital requirements directive IV, the EU implementation of Basel III, contained over 150 national discretions and variations raising questions over whether its compliant with the Basel framework.
Meanwhile, the EU is contemplating forcing foreign banks to hold billions in extra capital to operate in the Union as part of resolutions plans apparently in retaliation for a US move to do the same in 2014. Such developments have worrying implications for cross-border cooperation and accords.
Trump’s presidency, could be the start of a de-regulation cycle and a slide towards greater global regulatory fragmentation. With the new administration likely to shape the US’s regulatory framework to suit its socio-economic goals raises concerns over the prospect of another financial crisis. That’s certainly one point of view.
Another is that it could be a move towards more proportionate regulation, tempered by financial stability considerations, that liberates economic performance. Roemer at Barclays says supervisors were already more pro-active in seeking feedback and wanted to be more efficient, responsive and objective.
The new administration’s emphasis on cost-benefit analysis, greater transparency, accountability and eliminating counter-productive and duplicative rules could reinforce that trend.
Many of the new global rules were rushed into service following the financial crisis and are nearing completion. Now might be an opportunity to fine tune them so they deliver their objectives more effectively. After all Trump, does not want to be remembered for creating another financial crisis.